ValueInvestorInsight Issue 284

ValueInvestor
February 28, 2011
The Leading Authority on Value Investing
INSIGHT
F E AT U R E S
Everything at a Price
Stock prices are more prone than ever to rapid changes that don't reflect business fundamentals a state of affairs playing directly to Jon Jacobson's strengths.
Inside this Issue

Investor Insight: Jon Jacobson Comparing the markets take with his own and finding unrecognized value in DirecTV, CVS Caremark, SLM PAGE 1 Corp. and Vodafone. Investor Insight: Jed Nussdorf Looking for potential revenue-driven outperformance and finding it in Arch Capital, GAM Holding, WellPoint and State Street. PAGE 1 Strategy: Seth Klarman Excerpts from his annual letter on the nations economic predicament, two key elements to investing success, and the upside of short-selling. PAGE 18 Uncovering Value: Alliance One A potential example of how the timeworn insurance adage that there are no bad risks, just bad prices, applies to investing as well. PAGE 22 Editors' Letter Pondering how a value investor tag could confuse investors. PAGE 23
INVESTMENT HIGHLIGHTS INVESTMENT SNAPSHOTS
Alliance One Arch Capital
ike many excellent investors, Jon Jacobson can be prone to betting analogies. There's an old saying in poker that if you're not sure who the patsy is, you probably are, he says. You cannot have an opinion about an investment unless you understand the consensus and can articulate why it's wrong. If you can't do that, you're most likely the patsy. Jacobson has been nobody's patsy as an investor since he and partner Richard Grubman founded Highfields Capital in October 1998. Since then, a day-one investor has earned a net annualized 12.6%, vs. 3.6% for the S&P 500. With a practiced eye for the shunned and out-of-favor, Jacobson sees value today in such areas as pay TV, drugstores, student lending and wireless services. See page 2
INVESTOR INSIGHT
Jon Jacobson Highfields Capital Management Investment Focus: Seeks companies in which the odds favor their business challenges proving to be less onerous than what is reflected in the current market price.
In Context
Industries evolve just as companies do. Soapstone Capitals Jed Nussdorf keeps a keen eye trained on both to uncover mispriced investment opportunities.
INVESTOR INSIGHT
Jed Nussdorf Soapstone Capital Investment Focus: Seeks companies that are well-positioned in industries with structural or cyclical tailwinds which have yet to be adequately appreciated by the market.
ith the financial, strategic and administrative support of Joel Greenblatt's Gotham Capital, Jed Nussdorf launched Soapstone Capital in the fall of 2005 with a particular luxury. The money at first was just my own and Gotham's, he says, which allowed me to focus and learn as much as I could without the scrutiny of outside investors. He has so far learned his lessons well. Through a particularly tumultuous period, Nussdorf's long/short equity fund has earned a net annualized 8.0%, vs. 2.8% for the S&P 500. With a primary emphasis on industries with improving dynamics, hes finding opportunity today in such areas as trust banking, asset management, and health and See page 10 property/casualty insurance.
www.valueinvestorinsight.com
PAGE 22 12 6 5 13 7 16 8 15
CVS Caremark DirecTV GAM Holding SLM Corp. State Street Vodafone WellPoint
Other companies in this issue:

Anadarko Petroleum, Charles Schwab, CIT Group, Encana, Lender Processing Services, Potash Corp., Shoppers Drug Mart, Universal Corp., Verizon, Wells Fargo
I N V E S T O R I N S I G H T : Jon Jacobson
Investor Insight: Jon Jacobson

Jon Jacobson of Highfields Capital describes how a certain paranoia informs his investing strategy, the repeatable process he employs to analyze energy firms, how his hedging strategy has evolved, which primary macro concern he's focused on in the U.S., and why he sees unrecognized value in DirecTV, CVS Caremark, SLM Corp. and Vodafone.
When we last spoke [VII, February 28, 2006], you emphasized how volatility creates ideas. What sources of volatility tend to attract your attention? Jon Jacobson: There are two kinds of events that create volatility. The first revolve around individual companies, such as earnings misses, unexpected news, M&A activity, restructurings and legal issues things that can make prices and valuations change relatively quickly. In general, prices change much faster than fundamentals of businesses change, so what we want to do is understand what made the price change and then figure out whether the facts have changed as much as the price. To the extent they havent, that can be an opportunity. The other major source of volatility is when a macro event or trend causes markets to move. These can be industry specific, but also reflect interest rate moves, currency moves, political instability and the overall economic outlook. The market reflects at any moment what investors think XYZs business is worth, so if macroeconomic factors force people to buy and sell its securities but we believe those factors have nothing to do with the underlying fundamentals of the company or less to do with the fundamentals than is being reflected in the share price that can also be an opportunity. Give some examples of company-specific events youve acted on in the recent past? JJ: Id first point out that a lot of the intellectual property in a firm like ours is the fact that weve modeled many hundreds of companies over many years, always trying to understand the businesss earnings power, its cash-flow characteristics and its capital dynamics. When we know a business well, we can in a relatively short period of time evaluFebruary 28, 2011
ate the impact a news item is going to have and make a judgment on how well its reflected in the stock. We initiated last quarter a small position in Lender Processing Services [LPS], which is the nations leading provider of mortgage processing services, real-estate settlement services and default solutions. Its an industry in which weve invested many times, and LPS itself was spun out in 2008 from a company we know very well, Fidelity National Information Services. Negative media and regulatory focus on the foreclosure process including specifically on LPS default-solutions unit caused its share price to decline significantly, from the low-$40s early last year to the mid-$20s in October. We were able to reasonably quickly get up to speed and concluded that any cost to LPS to rectify past mistakes would likely be much less than the market was discounting, and that increased regulation could actually expand demand for the companys products and services. Given the fears, though, we were able to buy at around 7x our 2011 earnings estimate. We also bought shares in the middle of last year of Shoppers Drug Mart [SC:CN], Canadas leading drugstore franchise. Its a company weve long admired, with excellent market share and several macro tailwinds, but the stock was always too expensive for us. That changed when the Ministry of Health in Ontario, where 50% of Shoppers stores are, mandated a significant reduction in pharmacies drug pricing and reimbursement levels, which will reduce pharmaceutical-related revenues over the next three years. Our view was that the market overreacted to the news taking the stock down to 11x our estimate of post-reform earnings ignoring Shoppers ability to offset these changes by increasing fees, cutting costs, and, most significantly, stepping up consolidation of smaller indewww.valueinvestorinsight.com
Jon Jacobson
Natural Evolution
When Jon Jacobson and Richard Grubman started Highfields Capital in 1998, there was no scraping by with meager assets as they got established. Highfields started with $1.5 billion in capital, $500 million of which came from Harvard's endowment, Jacobson's previous employer. I'm the first to recognize the importance of timing, and luck, in one's career, says Jacobson. Post-crisis, post-Madoff, the start we had is virtually impossible today. They've taken full advantage Highfields now manages nearly $12 billion. Jacobson doesnt expect Highfields to miss a beat after Grubman's retirement at the end of last year. He credits mutual respect and complementary skill sets for the enduring success of his partnership with Grubman, who did more of the heavy lifting in activist situations Enron's Jeffrey Skilling famously called him an asshole in one testy conference call and the internal management of the firm, while Jacobson focused more on portfolio and risk management. It's a credit to the team we've built that our senior people have been more than capable of taking on more responsibility, both internally and externally, says Jacobson. As youd hope it would be, its been a natural evolution.
Value Investor Insight 2
pendent retailers that would be disproportionately hurt by the reforms. One higher-profile example last year was our purchase of Anadarko Petroleum [APC] after the Gulf oil spill. Anadarko was a 25% partner of BPs in the Macondo well, so we had to handicap several things, including the ultimate liability from the spill, Anadarkos share of the liabilities based on the joint operating agreement between BP and its partners, and the ultimate impact of the governments offshore drilling moratorium. Our view was that the market reaction taking Anadarko stock that was trading at 80% of our appraisal value of net assets prior to the spill and cutting it in half was overdone, so we made the decision to invest. Since the financial crisis hit weve been hearing much more from managers about the importance of business quality in sourcing ideas. Whats your take on that? JJ: Every investor will tell you that he or she looks for three things in a potential investment: a good business, run by a good management team, trading at an attractive valuation. Since everybodys looking for the same thing, it should be no surprise that you typically do not find all three at the same time. If one is really a value investor, paying a growth multiple is a non-starter, so we usually end up compromising on one of the other two. For us, that means either buying a bad business at the right price, or buying a good business that has a challenge. Sometimes the challenge is a lousy management team and if thats the case, you have to handicap if and when that can change. Starting in the middle of 2010 we did, like a lot of managers, find opportunities in high-quality companies. In many cases, companies that sported high single digit free cash flow yields and solid investmentgrade balance sheets (net debt of 1 to 2 times EBITDA) could borrow 10-year money in the credit markets at 4% before any tax benefit, when they were paying a 3% dividend yield to their shareholders. That didnt make any sense and it made us
February 28, 2011
exceptionally bullish on companies who recognized they could substitute expensive equity with cheap debt and foster a re-rating of the share price. DirecTV [DTV], which Ill speak about later, is a perfect example of a company where the management team totally gets that. Im generally not obsessed with quality. Good assets bought at the wrong price can be terrible investments, just as lousy ones bought very cheaply can generate excellent results. In the fall of 2008, for example, super-senior tranches of resi-
You spoke at length last time about your methodology for analyzing energy stocks. Whats it telling you about the attractiveness of the sector today? JJ: What we basically do is compare where a companys stock trades relative to the net asset value it could realize if it liquidated over time its proven reserves at prevailing forward market prices. When we believe on a present-value basis that were buying assets managed by capable people at a significant discount to our estimate of net asset value, thats interesting. Using this methodology, energy stocks got very cheap again a year or so ago, but have since moved much closer to our NAVs. Oil prices, until recently, havent done much in the past six months, but the perception is that oil companies are going to continue to grow earnings, so the stocks have done very well and the discount gap has narrowed. We do see some opportunity today in natural gas. We put on a fairly sizeable position last quarter in Encana [ECA], the North American gas producer that at current production levels has a 30-year inventory of assets. Using current gas strip prices, we believe its valued at 75% or so of our appraisal and we see other ways to win in the stock, most notably if the big historical gap between gas and oil on a heat-rate-equivalent basis narrows, and if the current pricing environment fosters long-lived demand shifts toward natural gas for power generation, transport or export. How generally do you look at valuation? JJ: Were trying to find 20 to 30 long investments, run by management teams that truly understand the cost of capital and capital allocation, where we believe based on a dividend-discount model that were paying 60 to 70 cents on the dollar today and that that dollar can grow at an equity rate of return. If you can buy a 60cent dollar and over three years that dollar appreciates 10% per year and the discount closes, the stock will more than double. You obviously wont do that on every position, but if you hit that on half
ON INEFFICIENCIES: In general, people are momentum investors, which can create opportunity for those who are disciplined and patient.
dential mortgage-backed securities [RMBS] backed by pools of no-doc, negatively amortizing adjustable-rate mortgages were trading for less than fifty cents on the dollar. As the performance of the underlying mortgages deteriorated, many RMBS holders liquidated, irrespective of price. As that happened, our analysis suggested we could buy at mid-teens or higher yields to maturity, even assuming that the vast majority of borrowers defaulted and that home prices kept going down. These were obviously terrible investments at par, but there is a right price for everything these RMBS investments have performed almost exactly in line with what we modeled. That anything is attractive at a price might seem intuitively obvious, but many investors consistently ignore it. People feel better in our business when prices are going up, so you consistently see buyers come in after markets have been good, while people tend to move to the sidelines and watch when markets are bad. People are, in general, momentum investors, which is completely at odds with being a value investor and which can create opportunities for those who are disciplined and patient.
your positions on average and dont lose any money on the other half, youll earn 13-14% per year. Id stress here the importance we put on handicapping the downside. To be successful in any business you have to have a certain competitiveness and a certain paranoia. In our business where they keep score every day and your problems are staring you in the face, you need to be incredibly focused on the problems in the portfolio and constantly assess whether your analysis is right and the consensus is wrong. Theres a fine line between having done your homework and having conviction in it and just being stupidly stubborn. The best investors figure out how to walk that line, recognizing their mistakes and moving on when the situation warrants. All of that is very hard if it were easy, everyone would be good at it. Describe your shorting strategy. JJ: Our hedging falls into three primary buckets, which vary in emphasis over time. Typically the biggest one is a global market hedge, in which we use things like index options and futures or credit default swaps to insulate the portfolio, to a defined level, from big market dislocations. The second bucket is directly related to what we own, in which well hedge against a commodity price, a currency, or another industry player in a relative-value trade. In energy, for example, were usually trying to isolate the relative value between stock prices and commodities futures prices. In those cases well short the oil and gas curve, to guard against the long bet getting washed out if commodity prices fall. Another example would be if we own Ford and believe not only that its absolutely cheap but also cheap relative to GM or BMW, we may short one of those to hedge against a general auto-industry decline. The last bucket includes shorts in individual stocks where were trying to create alpha. Its been increasingly difficult to do this for a lot of technical and competitive reasons, which is why a lot of people have given up on it. We havent given up, but as a percentage of the hedging we do its currently the smallest.
February 28, 2011
Do you manage to a target net exposure? JJ: We dont. Our investors have said from the beginning theyre looking for equity-like returns with much less risk. Weve delivered that over time by being 20-60% net long in our equity portfolio, which has been the lions share of what we own. Our net exposure now is in the low-40% range, which is a by-product of the opportunity set. You bought gold as an inflation hedge in 2008, but were mostly out of it by mid2009. Does that mean youre no longer worried about inflation? JJ: Im probably less worried than the run-of-the-mill talking head on TV, but
Whats your typical investment horizon? JJ: Id love for it to be shorter for the right reasons, but our typical core-position holding period is two to three years. It can be longer when the intrinsic value is growing fast enough that the discount remains attractive. Given our value bias, we tend to buy early and sell early. Often in our best investments the shareholder base changes, from value investors to GARP investors, and we miss out as that full transition takes place and the true believers completely take over. Ive come to accept that and consider it kind of inevitable with a value discipline. Describe your broader investment thesis for DirecTV. JJ: I mentioned earlier that value investors usually have to compromise on the quality of the business or management to be able to buy at a value price. This is a case where we dont believe were compromising on anything. DirecTV is the largest pay television provider in the world, with around 19 million subscribers in the U.S. and 6 million in Latin America. In the mature U.S. pay-TV market it has consistently grown market share over the past 18 months, accounting for two-thirds of industry subscriber adds over that period. We believe a combination of exclusive programming (such as the NFL Sunday Ticket package), superior product innovation (including video-on-demand, 3D TV and integrated broadband and TV services), and highly sophisticated marketing (particularly in how they segment customers) should allow the company to maintain a product and marketing edge and keep that momentum going. Another big positive is the Latin American business, which we believe can increase its subscriber base by 50% over the next five years as the overall market adds an additional 25 to 30 million subscribers. Looking out three years, we think Latin American revenues, the bulk of which are coming from Mexico and Brazil, can grow 18% per year.
ON SELLING: The best investors figure out how to walk that line between having conviction and just being stupidly stubborn.
the real answer is that we thought gold in the $800 per ounce range had the best upside/downside optionality as an inflation hedge as long as inflation didnt come on quickly and in a big way, which we didnt expect. When gold got to $1,100-1,200 per ounce and there hadnt been any real inflation, the bet became more symmetrical in our view, so we sold. Its obviously gone up since then, but we made pretty good money on it considering our reason for buying never happened. Sometimes its better to be lucky than smart. Id add that we look at the mining industry in the same way we look at energy, doing appraisals based on the forward commodity-price curve. Since we sold our gold, weve found a few gold-mining stocks that have worked out quite well. Would you rather invest in gold that way? JJ: Everything at a price.
You mentioned capital management earlier what are they doing on that front? JJ: Management has been clear it intends to right-size the capital structure for the free cash flow characteristics of the business. They think the equity valuation is absurd relative to where the company can borrow money, so with no major deals on the horizon and the ability to borrow at 3% after-tax to buy stock with a 10% free cash flow yield, they will continue to incrementally lever the balance sheet to buy back stock. Theyve publicly stated theyd like to get net debt to EBITDA to 3x, up from less than 2x today.
INVESTMENT SNAPSHOT
We expect the company by the end of 2013 to buy back at least $15 billion worth of stock. With overall revenue growth of 7-8% per year, modest margin expansion and reduced capital spending, we think both earnings and free cash flow per share will more than double over that time. How do you handicap the risk that overthe-top programming delivered through the Internet disintermediates pay TV? JJ: Theres no question new video platforms will continue to proliferate and there will be subscribers who cut the cord
DirecTV
(Nasdaq: DTV)
Valuation Metrics
(@2/25/11):
Business: Largest pay television provider in the world, with more than 25 million satellite-TV subscribers primarily in the United States and Latin America. Share Information
(@2/25/11):
to try to save money. But the average American consumes three hours of TV daily and many tent-pole events like live sports, the Academy Awards or American Idol will not be made available on an over-the-top basis and are more suited to a large-screen experience. So cord-cutting is more likely to be among lower-end customers who arent paying for a high-quality service like DirecTVs anyway. Id also point out that pay TV proved to be highly defensive through the economic downturn, with subscriptions growing every year despite the pressure on disposable incomes and the slowdown in household formations. As DirecTVs value proposition continues to improve and its programming becomes more available when people want it and on whatever device they choose, we think the business will remain quite resilient. With the shares trading at $46, how are you looking at valuation? JJ: Free cash flow per share for 2010 was just under $2.90 per share. We expect that to grow for the reasons I mentioned to almost $3.80 this year, $4.65 next year and more than $6 in 2013. So on next years estimate, the stock currently trades at a free cash flow yield of 10%. Were targeting a share price 18 months out of $60-65 per share. We get there in a variety of ways, including applying multiples of 10x forward free cash flow, 5.5x EBITDA, 8.5x operating cash flow (EBITDA less capital spending) and 13.5x EPS. All of those are consistent, if not conservative, relative to other publicly traded businesses with similar free cash flow characteristics. How exposed is DirecTV to an NFL football labor impasse? JJ: NFL Sunday Ticket subscribers make up roughly 10% of U.S. subs, but from a purely financial standpoint the company is reasonably well protected. If a certain number of games are played next season, it pays on a pro-rata basis for those games only. If the entire season is cancelled, it will be required to make a miniValue Investor Insight 5
Trailing P/E Forward P/E Est.

(@12/31/10):
DTV 27.3 11.7
Nasdaq 13.8 16.3
Largest Institutional Owners
Price
52-Week Range Dividend Yield Market Cap
Financials (TTM):
46.03
32.85 46.90 0.0% $38.38 billion $23.46 billion 15.6% 6.6%
Company Capital Research Global Inv Southeastern Asset Mgmt Primecap Mgmt State Street Vanguard Group
Short Interest (as of 1/31/11):
% Owned 6.9% 6.1% 4.8% 4.3% 3.7% 1.4%

50
Revenue Operating Profit Margin Net Profit Margin

DTV PRICE HISTORY 50
Shares Short/Float
40
40
30
30
20
20
10
2009
2010
2011
10
THE BOTTOM LINE
With revenue growth of 7-8% per year, modest margin expansion, reduced capital spending and significant share buybacks, the company can more than double earnings per share over the next three years, says Jon Jacobson. Applying peer multiples to various of his earnings estimates, he targets a share price of $60-65 within 18 months.
Sources: Company reports, other publicly available information
February 28, 2011
mum payment to the NFL, though some of that payment will be credited against the 2012 season and payments in later years would also come down. This would also trigger an automatic one-year extension at the end of the contract to make up for the lost year. The perceived negative effect of a strike or lockout would probably exceed the real effect, but the perceptions could very well impact the stock. The company is often mentioned as an acquisition candidate. Do you see that in the cards? JJ: In my view DirecTV has way too much strategic value for a company like AT&T or Verizon for that not to be in the cards. AT&T doesnt really have a competitive video solution against the cable providers. Verizon has spent $30 billion on FiOS for three million subs, while DirecTV has an enterprise value of $4045 billion and has 25 million subs. Theres just a huge disconnect there. CVS Caremark [CVS] has hardly been an investor favorite in recent years. What do you think the market is missing? JJ: We very much like the retail drugstore business, which is essentially an oligopoly led by CVS and Walgreen. Its an excellent free cash flow generator, is relatively stable through economic cycles, and has some very large tailwinds from the aging population using more prescriptions over time and from a sharp uptick in genericdrug sales on which pharmacies make more money as multiple blockbuster drugs go off patent. Weve followed the business for a long time and there have been several competitive concerns, such as Wal-Mart getting very aggressive or mail-order taking share, but the reality has been that the convenience factor of pharmacies has made the business quite durable. The big issue around CVS, whose stock has gone nowhere in the past five years, is its acquisition a few years ago of Caremark, combining the retail business with one of the largest pharmacy benefits managers in the U.S. While thats providFebruary 28, 2011
ed some benefit to the retail business from increased leverage with suppliers, the acquisition has been pretty much a bust as the Caremark PBM has struggled and is losing market share. In hindsight, its become clear that Caremark had several above-market legacy contracts and that its management did a great job, so to speak, of selling at the right time. Im not convinced they should just split the two businesses. The company is out of favor and analysts dont know how to value it as it is which is what creates the opportunity so wed prefer that they first try to fix what they have before admitting they made a mistake and punting.
INVESTMENT SNAPSHOT
What are they doing to fix things? JJ: Management has done a good job over time integrating acquisitions and executing on the retail side. What they say is that Caremark was a roll-up that was never really integrated, and that they have considerable opportunity over the next 18 to 24 months to take out costs and make the PBM business run as well as the drugstores. I dont know if the operational skill set they have from the retail side is applicable to the PBM, but the direction of the effort makes sense. We also believe they can do a far better job with capital management. Their
CVS Caremark
(NYSE: CVS)
Valuation Metrics
(@2/25/11):
Business: Retail pharmacy chain and pharmacy benefits manager, primarily in the United States; fills or manages more than one billion prescriptions per year. Share Information
(@2/25/11):

(@12/31/10):
CVS 13.2 11.9
S&P 500 18.6 13.9
Price
Financials (TTM):
32.94
26.84 37.82 1.6% $45.07 billion $96.41 billion 6.4% 3.5%
Company Davis Selected Adv Franklin Resources State Street Vanguard Group Wellington Mgmt
% Owned 5.0% 4.3% 3.7% 3.6% 3.5% 0.9%

50

CVS PRICE HISTORY 50
Shares Short/Float
40
40
30
30
20 2009 2010 2011
20
THE BOTTOM LINE
Jon Jacobson believes the market is ascribing almost no value to the companys Caremark pharmacy benefits management business, which he believes could again earn $1 in EPS. Applying a peer multiple to PBM earnings and a 12-13x multiple on growing drugstore earnings, his target price for the shares is in the mid-to-high $40s.
historical reluctance to buy back shares is slowly changing, but wed argue the company should direct nearly all of the $3.5 billion or so in free cash flow it generates this year to share buybacks. Our playbook is the same as with DirecTV: If management has confidence in its ability to execute on its operating plan, theyre effectively saying that the consensus estimates for the business are too low and that theyre going to beat them over time. If thats true and they should have the most visibility into that the best thing to do is to shrink the share count before the outperformance is recognized by the market. That in itself will create permanent value accretion. What upside do you see in the shares from todays price of just under $33? JJ: We estimate the company will earn around $3 per share in 2012, three-quarters of that coming from the drug retailer and one-quarter coming from Caremark. Applying Walgreens current 14-15x forward multiple on the CVS business, that means the stock today reflects almost no value for Caremark. Say the PBM business can get back to the $1 or so of cash earnings per share it has earned in the past. At a 14x multiple, a discount to where competitors Medco and Express Scripts trade, thats $14 per share in value. If you then put even a 1213x multiple on the drugstores $2.20 per share in estimated cash earnings that we think are growing 10-12% per year, our overall target for the stock is in the midto-high $40s. Given that we see little or no downside from the current price, that offers nice optionality. Youve called student-lender SLM Corp. [SLM] a prototypical Highfields investment. Why? JJ: Sallie Mae is an orphan company that is complicated to analyze. When we first invested in it over two years ago, there was a considerable amount of political risk, as the Obama Administration was making noises about eliminating FFELP, the government guaranteed program for
February 28, 2011
student loans, Sallie's most-profitable business. On top of all that, the company had what appeared to be a highly levered balance sheet at a time when anything having to do with debt was universally perceived as a negative. Mindful of all the risks, we started buying the stock in 2008 in the high single digits, on the belief that the run-off value of the existing portfolio of government guaranteed loans, using conservative assumptions, was $7 to $17 per share on a present value basis. That meant we were getting the ongoing private lending, servicing and collections businesses essentially for free. It was the type of situation
INVESTMENT SNAPSHOT
that attracts us complicated and out-offavor for reasons we could identify as well as quantify. The stock then fairly quickly fell to $4 in early 2009. Did you buy more? JJ: We did. The nice thing about being a value investor is if the facts dont change and the company gets cheaper relative to your appraisal, you have a bigger margin of safety. Thats easy to say, but at the depths of the crisis it was a terrifying time to be buying anything, particularly something leveraged. The market thought the company was going bankrupt.
SLM Corp.
(NYSE: SLM)
Valuation Metrics
(@2/25/11):
Business: Largest student lender and loan servicer in the U.S.; transitioning from focus on government-guaranteed loans to those made without federal backing. Share Information
(@2/25/11):

(@12/31/10):
SLM 15.9 9.1
S&P 500 18.6 13.9
Price
Financials (TTM):
14.96
9.85 15.31 0.0% $7.88 billion $2.77 billion 56.3% 19.2%
Company Barrow, Hanley, Mewhinney & Strauss Highfields Capital Dodge & Cox Goldman Sachs T. Rowe Price
% Owned 10.1% 9.9% 9.0% 7.9% 6.2% 1.7%

25 20 15 10 5 0

SLM PRICE HISTORY 25 20 15 10 5 0
Shares Short/Float
2009
2010
2011
THE BOTTOM LINE
After surviving a shock to its business model and a crisis-induced debt scare, the company remains ignored and misunderstood, says Jon Jacobson. Valuing separately the run-off value of its federally guaranteed loans, its ongoing lending and servicing businesses, and its excess loss reserves, he believes the shares are worth more than $20.
With the crisis having passed and the shares now around $15, were surprised youre still invested. Why is it interesting today? JJ: Nine months ago we recommended this at the Ira Sohn Conference in New York at around $10. At the time, the market was grappling with concerns over Sallies private-loan portfolio, its debt maturities, and the path it might choose to deliver value to shareholders. Today all of those issues appear more positive: private credit delinquencies seem to have peaked, the company has repurchased several billion dollars of debt and has issued $2 billion of new long-dated, unsecured debt, and management has committed to returning capital to shareholders, likely starting in the second half of this year. In addition, the company has outlined an aggressive attack on its cost structure and also acquired Citigroups $28 billion government-backed studentloan portfolio on very attractive terms. The value in the business today consists of the guaranteed-loan portfolio in run-off, as well as ongoing businesses making private student loans and servicing and collecting both government and private credits. We value the run-off portfolio at $9 per share on a present value basis. The rest of the businesses we believe can generate at least $1 per share of normalized earnings, with growth potential as the servicing business ramps up and as the costs of higher education continue to rise, necessitating more and bigger loans. Assuming a 10-12x multiple on that $1 (and growing) earnings stream, we think Sallies business today is worth around $20 per share. In addition, there are $2 billion in loan loss reserves embedded in the balance sheet, a good portion of which we expect to ultimately be released, which would be worth another $1-2 per share. We think theres a reasonable chance that the company starts to pay a meaningful dividend by the end of this year, at a yield of 3% or more. While that doesnt make or break the investment case, its indicative of the latent value we believe still exists.
February 28, 2011
Youve also done well with your Vodafone [VOD] stake why do you think it still has further to run? JJ: Vodafone is the largest wireless phone service provider in the world, operating in Europe, Asia, Africa, the Middle East and the U.S., where it owns a 45% stake in Verizon Wireless. Given its footprint in multiple global jurisdictions with various sub-100% ownership stakes, wed argue its widely misunderstood by analysts who follow it. How so? JJ: Todays equity valuation to us implies a low likelihood that full value is realized with Verizon Wireless, an expected resumption of the companys misguided
INVESTMENT SNAPSHOT
M&A strategy, and/or grave concerns about the viability of the non-U.S. businesses. We actually expect the Verizon situation to be resolved more quickly and favorably than is being discounted, that the company will sell off non-core assets and return more than 10% of its market cap to shareholders over the next twelve months, and that the operational outlook outside the U.S. is improving. Describe what you mean by the Verizon situation. JJ: Verizon Wireless is an excellent business, with revenue growth in the high single digits, mid-40% EBITDA margins and 30% operating cash flow margins. The problem from Vodafones standpoint, however, is that the business has
Vodafone
(London: VOD:LN)
Business: World's largest wireless services company by revenue, with core majorityowned operations in Europe, South Africa and India; owns 45% of Verizon Wireless. Share Information
(@2/25/11, Exchange Rate: $1 = 0.62):
Financials (TTM)

Valuation Metrics
(Current Price vs. TTM):
$73.49 billion 14.4% 25.1%
Price
1.75 1.26 1.85 5.4% 90.54 billion
P/E
VOD 8.1
S&P 500 18.6
VOD:LN PRICE HISTORY 2.00
2.00
1.50
1.50
1.00
2009
2010
2011
1.00
THE BOTTOM LINE
The market is overestimating the risk that the company misuses capital, the extent of its operating trials outside the U.S., and the challenges it may face in realizing value from its Verizon Wireless stake, says Jon Jacobson. Based on a sum-of-the-parts valuation of the companys various business units, he pegs todays share value at 2.50.
essentially been run on a breakeven free cash flow basis, with all cash being poured back into the business. That isnt terrible if the investments are made intelligently and increase intrinsic value, but its generally viewed to be high time for Vodafone shareholders to start to see some cash from their 45% stake. Our feeling is that time is near, as the parent Verizon is forced to institute a regular dividend at Verizon Wireless in order to support its own dividend at the holdingcompany level. The math behind that: As Verizons legacy wireline business structurally declines, we estimate it will earn approximately $8.5 billion of EBITDA in 2012, against which it will have $5 billion in capital expenditures, $2 billion in interest expense and $1 billion in cash taxes. That leaves it not much better than breakeven on a cash flow basis, against which it implicitly has to support $5.5 billion in annual corporate dividends. That funding hole has to be plugged and a dividend from Wireless which we estimate by 2012 will generate $15 billion in free cash flow ($6.75 billion of which is applicable to Vodafone) would certainly do the trick. How do you arrive at an intrinsic value for Vodafone, now trading at 1.75? JJ: We estimate the businesses currently generating cash everything but the U.S., Turkey and India will earn around 6.8 billion in 2012. Vodafones share of Verizon Wirelesss 2012 cash flow is estimated to add another 4.2 billion. At a 9% cost of equity, or 11x free cash flow, that gives a conservative implied equity value of those businesses of 123 billion. On top of that, we value the Indian and Turkish businesses at 5x EBITDA, adding another 6 billion or so in value. With 51 billion shares outstanding, that results in a sum-of-the-parts value of more than 2.50 per share. Thats the value today, which we expect to grow as the overall market expands, shares are repurchased, and non-core assets are sold at higher multiples than we use to get to the 2.50.
February 28, 2011
Coming at it another way, if you assume Vodafones stake in Verizon Wireless is worth 6.5x EBITDA conservative given the companys market position and margin structure and assign a 20% liquidity discount to the stake, the remainder of Vodafone today is trading at a 14% free cash flow yield and a 10% dividend yield. That just strikes us as unreasonable. With the benefit of some distance, what do you take away from Highfields rough sledding in 2008? JJ: We generally want our investments to be uncorrelated to macro factors, but if
ON STATE BUDGETS: If states meaningfully reduce the overall cost of labor, the investment implications could be hugely positive.
you look back at the portfolio and what really cost us, it was that our top 10 to 12 positions, without exception, were perceived by the market to be closely aligned with global GDP growth. Even in businesses we didnt think were that cyclical, they were perceived to be cyclical and the stocks got killed. Part of the problem was that a lot of correlations went to one, so there was nowhere to hide. But I fault us for not recognizing the vulnerability across the portfolio to the same macro problems. We organize ourselves around industries, and one thing weve tried to improve is the exchange of ideas and criticism among our analysts. People communicated very well up to me, but not well across our industry verticals. Thats now 300% better, which should not only help us to better understand correlations, but also to sharpen the discussion over the relative value and merits of each individual idea. Another lesson is that there is no such thing as permanent capital. We have one
of the most stable, long-term groups of limited partners in the business, but we had 10% redemptions in 2008, the highest wed had to that point by a factor of four. The bigger problem, though, was that we owned things that people who had 30% redemptions were forced to sell at any price. We didnt have to sell in any meaningful way, but we also didnt have the ability to really back up the truck and buy like we should have. We didnt institute any new rules on this front, but I would say we have a heightened consciousness about liquidity, and about the types of limited partners we take money from. Weve always been more concerned about who our investors are than how much capital they give us we were reminded why in 2008. What macro worries are top of mind for you today? JJ: I wrote in one of our investor letters last year that we had spent more time analyzing politics in the prior six months than we cumulatively had for our entire careers. Virtually every industry we follow seems to have some sort of political headwind, so one worry is about policy error where its most likely and the ramifications thereof. This is all one big grand experiment were working through here. Another thing were thinking a lot about is the escalating confrontation which has already started, by the way in the U.S. between the public-sector unions, private-sector creditors and taxpayers. Its not a stretch to imagine the resulting acrimony leading to disruptions in public services, more financial-sector volatility and possibly some social unrest in the not-distant future. If that sounds dramatic, look at all thats happening in Wisconsin. Someone, maybe everyone, is going to take pain as this plays out. If the states find a way over the next 18 to 24 months to meaningfully reduce the overall cost of labor, the investment implications for most markets could be hugely positive. The opposite could be hugely negative. As we said at the beginning, volatility creates opportunity. VII
I N V E S T O R I N S I G H T : Jed Nussdorf
Investor Insight: Jed Nussdorf

Soapstone Capital's Jed Nussdorf explains why small-caps don't fit well with his strategy, why he requires valuations that are absolutely rather than relatively cheap, which down-and-out sector has most piqued his interest, how his portfolio went up in 2008, and why he sees mispriced value in Arch Capital, GAM Holding, WellPoint and State Street.
Youve said a guiding principle of yours as an investor is, Dont fight the fundamentals. What do you mean by that? Jed Nussdorf: Many opportunities I pursue have a thematic, top-down element, where an industrys structure or certain situational dynamics are a tailwind to the companys business. It may be the industry has consolidated or supply is otherwise tightening, resulting in pricing power for the key players. It may be a company with a structural cost advantage that will allow it to take market share and accelerate revenue growth over a long period of time. The point is that I focus on the fundamentals of the business first, not on how cheap the stock is or how much its off its 52-week high. That helps me avoid value traps and/or businesses with structural challenges. The classic example in recent years where the fundamentals lined up nicely is the railroad business. Having painfully jettisoned excess capacity during 25 years as price takers, railroads in 2004 finally saw underlying demand growth catch up with supply and they became price makers. That dynamic led to operating margins in the business going from around 10% to as much as 30% last year, and railroad-company shareholders were well rewarded. I was attracted to the sector not because the stocks were down at the time or that they were cheaper than they had been historically, but because the business had inflected in a material way. Incidentally, my view on the industry has shifted. Returns on invested capital now approach or exceed levels that regulators might consider acceptable. The new head of the Surface Transportation Board has been outspoken in his efforts to protect the interests of shippers, so Ive been out of the sector since the end of 2010 as equity valuations hit cyclical highs on all-time-peak earnings estimates.
February 28, 2011
Will you bet on commodity cycles as well? JN: Its usually not the sole basis for the thesis, but I will own commodity stocks if I have a constructive view on the price of the underlying commodity. I made fertilizer producers Potash Corp. and CF Industries core holdings starting in late 2009 in large part because I had a very constructive view on corn prices as they approached $3.50 per bushel. Fertilizer is generally a tax-deductible expense for farmers, so they tend to buy a lot more of it when they make more income, and they make more income when the price of corn goes higher. I believed overall potash supply was constrained and there was considerable pricing leverage for fertilizer if corn prices did go up. In this case my view has also changed. Everyone seems focused on the global demand story, but with corn today at $7 per bushel theres likely to be a strong supply response as farmers increase acreage devoted to corn, and we could start to see demand pull back from exports and feedstock suppliers. At the same time, government support for ethanol, the production of which now uses up almost 40% of the U.S. corn supply, may become more tricky once the recent surge in corn prices hits U.S. consumers at the supermarket. I dont know when or if any of this happens, but the risk has increased sufficiently that Im no longer invested in the sector. What sectors are you finding interesting on the long side? JN: Property/casualty insurers are in a soft pricing market that has gone on for seven years, which is very long by historical standards. Im not sure a hard market comes any time soon, but theres evidence that market participants are being more disciplined and arent chasing prewww.valueinvestorinsight.com
Jed Nussdorf
Haste not Waste

While most careers involve detours and changes of direction, Jed Nussdorf's has thus far been a model of efficiency. After completing a joint program in engineering and business at the University of Pennsylvania in just three years, he submatriculated at the Wharton School, graduating with his MBA in 2003. He then spent two years working for Force Capital's Robert Jaffe [VII, December 22, 2006] a period in which the firm's assets grew from less than $100 million to more than $1 billion before striking out on his own to form Soapstone Capital in 2005. Nussdorf didnt rush things at the outset. Soapstone initially limited its partners to Joel Greenblatts Gotham Capital and its affiliates, declining offers to take on external investors. I was only 25 years old and I realized I had a lot to learn before accepting the responsibilities associated with managing outside capital, he says. He credits Greenblatt with providing key guidance on portfolio strategy, construction and risk management, insights he evidently put to excellent use after opening his fund to outside investors in 2007. In the market meltdown of 2008, Nussdorf guided Soapstone to a net portfolio gain of almost 5%.
mium growth at the expense of underlying profitability. It helps that many of the players stocks trade at or below book value, which makes share repurchase an efficient means to distribute excess capital. Ill elaborate on this when I speak about Arch Capital [ACGL], but its fairly rare to be able to buy into a cyclical business near the trough of the cycle and at trough multiples of earnings and book value. I believe thats the case in property/casualty insurance today. Can you name a sector more ripe today for shorting? JN: There's considerable excess capacity in the U.S. railroad-input sector, with a surfeit of freight cars and locomotives that won't be put back into service for a long time. The companies in this sector are trading at peak multiples on the hope of a rebound, but as railroads continually improve cycle times and efficiency, I don't see a robust rebound for input providers. If youre a maker or lessor of cars and locomotives, thats a negative. How do you generate ideas? JN: The more thematic ideas typically revolve around understanding and interpreting the drivers of pricing in an industry and making a call on where prices are headed. I also come at things from a bottom-up perspective, looking for cases where value is obscured due to a corporate event such as an acquisition, spinoff or largescale restructuring or from complicated or less-than-transparent financial reporting. A typical example is GAM Holding [GAM:SW], a diversified asset manager that is currently my largest position. We had been a shareholder of GAM's former parent, Julius Baer, and I held the executive team there in very high regard. I was intrigued when Julius Baer decided to split up and that the top Baer management team planned to run the smaller and less prestigious asset management operation, which is now GAM. Thats unusual and suggested that they saw particular value in it.
February 28, 2011
What caught your eye in discount broker Charles Schwab [SCHW]? JN: This actually has both top-down and bottom-up aspects. From an industry perspective, I believe Schwab has built a strong competitive moat and will continue to gather a disproportionate share of assets in retail brokerage. In addition, it has a cost structure that is a fraction of its peers, which enables it to pursue strategic initiatives that competitors can't afford. The company has been proactive since the
a much better understanding of what constitutes consensus, and specifically how and where my view varies from it. In smaller companies that attract little attention, its harder to know the expectations embedded in the share price. Why do you prefer revenue-driven upside? JN: You generally make money in three ways on the long side: your estimates are higher than the Streets and the consensus moves to your numbers, the earnings grow, or the earnings multiple expands. By and large, the multiple is likely to expand the most in situations where revenue is accelerating. I dont typically center any thesis on multiple expansion, but its certainly nice to have it on top of growing earnings. How do you think about valuation?
ON MISTAKES: Theyve been when I thought I was getting a great deal on a house, only to find later a fire smoldering in the basement.
financial crisis in deepening client engagement by introducing a variety of new banking, credit-card and deposit products and services. All this good news, however, has been largely obfuscated in recent years by nearzero short-term interest rates, which both reduce Schwabs net interest margin and have also required large-scale fee waivers on its money market funds. As the interest-rate environment eventually normalizes, Id expect the true earnings power of around $2 per share to manifest itself. While the stock has historically traded at 18-20x forward earnings, even at 15x wed do very well from todays price [of around $19]. We could imagine a smaller fund like yours being weighted to small-cap stocks, which is not the case. Why? JN: I build an earnings model from scratch for every material position in the fund, which is the best way to understand the key drivers of the business and its profitability. Im looking for opportunities in which I have a differentiated view on forward earnings, preferably revenuedriven. By focusing on better-followed mid-cap and large-cap stocks, I can have
JN: I try to own businesses that are inexpensive in an absolute rather than relative sense. No position I own today trades at more than 15x my estimate of the next twelve months earnings. The only companies I own at more than 12x earnings are in businesses that I think are among the best in the world. The problem Ive found in paying higher multiples is that you can have a differentiated view on the business fundamentals and be absolutely right, but the risk is higher that the multiple contracts and takes away your positive return. That doesnt have to happen, of course, but I want to credibly believe the multiple trajectory is biased upwards, even if thats not the primary reason Im investing. Id reiterate what I said earlier about not fighting the fundamentals. When I look at mistakes Ive made like buying the best sub-prime mortgage lender in late 2006 theyve primarily been when I thought I was getting a great deal on a house, only to find out later there had been a fire smoldering in the basement. The obvious lesson is that things that look cheap arent necessarily so. In terms of return potential, I want to see at least 50% upside over the next 18 months, with at least two-thirds of that
coming from earnings growth and consensus estimate revisions, and no more than one-third from multiple expansion. How concentrated is your portfolio? JN: Another of my guiding principles is that there are significant diseconomies of scope in the investment business I only have a finite amount of time and I cant do sufficient analysis on my portfolio companies if I stretch myself too thin. As a result, I limit the sectors I follow to those in which I have some level of domain expertise, and I concentrate my number of holdings. My target portfolio is 12-15 longs, with a somewhat higher number of shorts. Today my top eight positions represent about 75% of my long portfolio. Describe why Arch Capital is your top choice among property/casualty insurers. JN: The company was started after 9/11 and writes both insurance and reinsurance on a global basis. Ive owned this for the past three years and the good news over that time is that even with a terrible underwriting and investment year in 2008 and unrelenting downward pressure on interest rates and insurance prices in 2009 and 2010, the company has grown its book value by just over $11 per share per year. The not-so-good news is that the market now values the company at a discount to book value rather than a premium. That masks a growth in intrinsic value that I believe is even higher than what weve seen in book value. Why? JN: Accounting is much more important in insurance than most businesses. When Colgate sells a tube of toothpaste it knows the cost of goods sold, but thats not true in insurance, where you likely wont know the cost of a policy sold today for many years. As a result, net income and book value are little more than estimates, driven by the level of reserves set aside for future underwriting losses. If youre overreserved, your net income and book value
February 28, 2011
will be understated, if youre underreserved, your net income and book value will be overstated. The story with Arch is about excess reserves. Over the past few years the company has reduced total written premiums, reduced the share of casualty vs. property coverage, and experienced declining actual losses across most of its underwriting lines. All else equal, each of those factors would put downward pressure on reserves, but Archs loss reserves are up more than 15% since 2007. You can see the extent of the total excess built up by looking at the relationship between what are called case and
INVESTMENT SNAPSHOT
incurred-but-not-reported reserves. Consistent with the underwriting trends I described, Arch has experienced declining case reserves, which cover losses for which the company has been specifically notified by an insured party. But it has more than compensated for that decline by increasing IBNR reserves, which cover losses not yet known to the company. As of December 31, 69% of Archs total reserves were IBNR, while the peer median is about 57%. That tells me theyre overreserved, especially given that their underwriting performance would justify less-than-peer IBNR reserves. If Arch released enough IBNR reserves just to
Arch Capital
(Nasdaq: ACGL)
Valuation Metrics
(@2/25/11):
Business: Bermuda-based provider of specialty insurance and reinsurance, with premiums roughly evenly divided between the two and generated primarily in the U.S. Share Information
(@2/25/11):

(@12/31/10):
ACGL 5.8 11.1
Nasdaq 13.8 16.3
Price
Financials (TTM):
89.90
65.70 92.50 0.0% $4.18 billion $3.24 billion 26.3% 26.0%
Company Artisan Partners Baron Capital Vanguard Group Aronson, Johnson & Ortiz Steinberg Asset Mgmt
% Owned 9.6% 6.3% 3.0% 2.1% 2.0% 4.9%

100

ACGL PRICE HISTORY 100
Shares Short/Float
80
80
60
60
40 2009 2010 2011
40
THE BOTTOM LINE
Were the company to underwrite to a 95% combined ratio, gradually release large excess loss reserves and continue to aggressively buy back stock, Jed Nussdorf believes it can compound book value and its share price at 20% annually. If the soft insurance pricing market hardens, the results would be that much better, he says.
match the industrys 57% level, that would result in a $30-35 per share increase in book value. Why are they overreserving? JN: Part of it is just prudence, but I believe one key reason involves how their underwriters are paid. Underwriters compensation is tied directly to the longterm evolution of underwriting profits and is paid out over a ten-year period. Not only is that sound business practice, but it also provides a road map for the release of excess reserves. As the first tenyear underwriting anniversary approaches, it makes sense that the company will start to release some of the excess, pay out a portion to underwriters and recognize the balance as income. How does all that affect your valuation of the stock, now trading around $90? JN: Arch earns $7.50 per share if it breaks even on underwriting. Every 100 basis points of underwriting profit is worth another 50 cents per share in earnings, so if it writes at a 95% combined ratio it earns $10 per share, an 11% return on equity. If you factor in the release of loss reserves at $3-5 per share per year over the next few years and assume continued share buybacks, the company can compound book value per share at 20% annually about what its earned on average since it was founded. Were that growth in book value to translate into comparable share-price appreciation, this would be a nice investment. But if the property/casualty insurance market hardens in the next couple of years and with property/casualty premiums at low historical levels relative to GDP and the soft market having endured much longer than usual, there are reasons for optimism it would be that much better. Recent reserve additions from AIG, ACE and Aspen, among others, suggest that we are now in the later stages of the soft market; once IBNR for the industry falls another 5 to 10 points as a percentage of total reserves, I think a hard market could emerge. In a hard market, Arch
February 28, 2011
stock would probably trade closer to 1.5x book value, rather than the 1x stated book today. I mentioned earlier that I dont source ideas based on something like a low price to book value. If I start there in the insurance industry, I probably dont end up with Arch, but instead with a proverbially crappy insurer with the weakest reserves. When you find an excellent company that does things the right way, every once in a while youre surprised to find that its much more inexpensive than you thought. Describe the continued upside you see in GAM Holding. JN: GAM Holding is a combination of two distinct entities, an alternative asset
INVESTMENT SNAPSHOT
management platform, mostly hedge funds, run from London under the GAM name, and a traditional fund management firm based in Zurich called Swiss & Global Asset Management. Roughly 60% of total assets are run out of the Zurich operation, while 40% are in alternatives. Profit-wise the percentages are switched, with roughly 60% coming from the GAM business in London. Management in this case is central to my thesis, so Ill give you some brief history on Hans de Gier and David Solo, who run the business. In 2005 they were in charge of three boutique private banks and the GAM alternatives business while it was all part of the big investment bank UBS. In 2005, they engineered a reverse merger of those businesses with the venerable, but sleepy, Julius Baer private bank
GAM Holding
(Zurich: GAM:SW)
Business: Swiss-based asset manager specializing in traditional and alternative fund management, with 117 billion Swiss francs in assets as of June 30, 2010. Share Information
(@2/25/11, Exchange Rate: $1 = CHF 0.93):
Financials (First half 2010)
AUM @ 6/30/10 Pre-Tax Profit Margin Net Profit Margin

Valuation Metrics
(Current Price vs. TTM):
CHF 116.6 billion 36.9% 28.9%
Price
CHF 16.15 CHF 11.25 CHF 18.05 0.0% CHF 3.34 billion
P/E
GAM n/a
S&P 500 18.6
GAM:SW PRICE HISTORY 20 15 10 5 0
20 15 10 5 0
2009
2010
2011
THE BOTTOM LINE
The market underestimates managements ability to drive both the top and bottom lines of the business, says Jed Nussdorf. Assuming a 13-14x forward multiple on his 2012 earnings per share estimate of 1.65 Swiss francs, plus 5 francs per share in cash, he believes the stock can trade around 27 Swiss francs a year from now.
and were put in charge of the combined entity. They cut costs, reversed fund outflows by expanding distribution and rejuvenating product development, and earnings dramatically improved as did the Julius Baer share price, which doubled within two years of the merger. When de Gier and Solo concluded that private banking and asset management were better off apart, they spun off GAM Holding and went to run it with an equity incentive package that gave them roughly 5% of the company. The spinoff was completed in late 2009 and weve owned it since, adding to our position on weakness in the stock last summer. Are they following the same playbook? JN: Yes, and to equally positive effect. The alternatives business has weathered the crisis and has been running doubledigit percentage increases in asset inflows. The traditional business has been growing nicely as well, fueled by expanded fund offerings, particularly those investing in commodities. All the while they continue to rationalize costs and increase margins. Is there a more thematic element to this idea as well? JN: Theres an argument to be made that the reawakening interest in equities and hedge funds on the part of institutions and individuals globally will work in GAMs favor over the next 12-18 months, given its distribution strength and great menu of products. But that's a pretty transient thematic, and fund flows can be volatile. Far more persuasive is the companys competitive positioning, its first-class management and its attractive valuation. With the shares now trading at 16.15 Swiss francs, describe the latter. JN: My earnings estimates at 1.25 Swiss francs per share in 2011 and 1.65 in 2012 are approximately 20% ahead of consensus. Two-thirds of that variance comes from my expectation that asset inflows
February 28, 2011
surprise on the upside, with the rest coming from the reduced cost burden of a long-term incentive plan. Good asset managers often trade at high-teens multiples and some in Europe trade there today. But assuming only a 13-14x forward multiple on my 2012 estimate, adding back 5 Swiss francs per share in cash and liquid investments, the stock would trade around 27 Swiss francs a year from now. Im being conservative in applying a market multiple to what I think is a better-than-market business.
ON HEALTH INSURANCE: Due to healthcare reform, the pricing has hardened more than would be typical in a garden-variety hard market.
Are you at all worried that the cash on the balance sheet will burn a hole in managements pocket? JN: They have cash to deploy, but its very unlikely theyll overpay for acquisitions. They have never overpaid for an acquisition before, and I think theyll be very disciplined. Ultimately, I wouldn't be surprised if their endgame is to sell the company in its entirety. The bigger risk with the stock is market-related, as another big dislocation would clearly hurt investment performance and asset levels. But as a long/short hedge fund, its easy to short out the risk of a falling market. Even if you werent constructive on the market overall, you could be constructive on this stock. Youve said your investment thesis for WellPoint [WLP] has moved from more defensive to offensive. In what way? JN: Since the latter part of last year, most of the healthcare reform-related issues have been quantified and there has even been positive news on the legislative and regulatory front for health insurers. Now I believe the story for WellPoint has
moved from the more defensive why everything wont be so bad, to a more optimistic why it will be good, particularly with respect to industry pricing. Health insurance goes through soft and hard markets like any other insurance business, and like property/casualty insurance, the major catalyst for a hard market is the recognition of underpriced business written in the past. Business was underpriced in late 2007 and early 2008, which catalyzed a return to disciplined pricing in 2009. But due to healthcare reform, the pricing has hardened more than it typically would in a garden-variety hard market. Please explain that. JN: The passage of healthcare reform, and more specifically the inclusion of Medical Loss Ratio [MLR] minimums, has created an asymmetric incentive structure for the carriers. If insurance is priced at inadequate rates, carriers bear the costs, but if pricing is high, they will be forced to refund the excess profits to their clients. In other words, they would only "own" the downside. Historically, if the industry had priced risk too low in a given year, they could increase pricing in subsequent years to recoup their lost profits and thereby capture the upside from wider underwriting margins. But after the passage of reform, this is no longer the case. As such, the industry has been unwilling to run the risk of pricing below trend, knowing that they will not be able to recapture any losses as they have in the past. If you talk to brokers in the market, theyre saying carriers are pretty uniformly jamming on price. I expect the new incentive structure created by reform will keep the market harder for some time, and certainly dont expect a soft market again for at least the next three years. How is that translating into your earnings estimates? JN: My estimates are considerably higher than Wall Street forecasts. Consensus EPS for WellPoint this year is $6.50 per share,
INVESTMENT SNAPSHOT
WellPoint
(NYSE: WLP)
Valuation Metrics
(@2/25/11):
Business: Largest U.S. health insurer by membership, serving some 35 million people primarily through Blue Cross and Blue Shield franchises in 14 states. Share Information
(@2/25/11):

(@12/31/10):
WLP 9.6 10.1
S&P 500 18.6 13.9
Price
Financials (TTM):
66.52
46.52 67.95 0.0% $24.98 billion $58.80 billion 8.1% 4.9%
Company State Street Corp Orbis Holdings Vanguard Group Barrow, Hanley, Mewhinney & Strauss BlackRock
% Owned 4.3% 3.7% 3.6% 3.2% 2.9% 0.9%

80 70 60 50 40 30 20
shares and maybe initiating a dividend. They havent done dumb things yet, but it could substantially disrupt the thesis if they did. One upside option is that the estimates out there for MLR rebates prove too high, which I think is a distinct possibility. Also, any sort of starving of the healthcare-reform beast either at the legislative or judicial level that renders reform less comprehensive and pervasive would likely be quite positive for the stock. What do you think the market is missing in trust bank State Street [STT]? JN: The company is in two primary businesses: custodial banking and asset management. The custody business, which accounts for more than 80% of total profits, serves asset manager clients with a wide variety of back-office services, from record keeping to trade execution to portfolio pricing. This is the more interesting business going forward, as State Street and Bank of New York Mellon have led a consolidation of this market over the past 10 years and are the top two global players in most of the relevant business lines. With the resulting prospect for more rational competitive behavior in the future, I think the custody bank can sustainably and profitably grow at least 10% annually. The asset management business oversees $2 trillion in assets, is also growing nicely, and earns competitive margins. Its primary focus is exchange-traded funds it is the second-largest ETF provider in the world and index funds, which positions it well in an industry in which passive investment strategies are growing faster than active ones, and ETFs are growing faster than index funds. It manages the two largest ETFs, SPDR S&P 500 and SPDR Gold Trust. The company has also had its share of missteps, the biggest of which was the existence of an asset-backed commercial paper conduit facility that invested in a whole host of toxic fixed-income assets. State Street was forced to consolidate the conduit at the nadir of the market, pressuring its capital levels. It has also been in

WLP PRICE HISTORY 80 70 60 50 40 30 20
Shares Short/Float
2009
2010
2011
THE BOTTOM LINE
The investment thesis for the company, says Jed Nussdorf, has shifted from a why it wont be so bad focus to a more offensive why it will be good one, based on increased pricing power. At 12x his estimate of what will then be the next twelve months earnings per share, the stock 18 months from now would trade around $100.
but I think theyll earn $7.25, with strong growth on top of that to $7.75 in 2012 and $8.75 in 2013. My estimates this year and next are driven by modest marketshare gains and aggressive share buybacks. This company has generated $18 billion in free cash flow over the last five years and has repurchased more than $21 billion of its own stock, halving the outstanding share count. My 2013 estimate also shows additional benefit from normalization in the economy assuming they get back 500,000 of the two million policyholders lost in the recession, for example and some benefit from higher interest rates earned on their float.
February 28, 2011
How do you see that translating into share-price upside from todays level of $66.50? JN: If in mid-2012 the consensus matched my then forward 12 months earnings expectation of around $8.25 per share, and the market attached a conservative 12x multiple to that, the stock would trade at about $100. What are the biggest risks? JN: The biggest concern would be if WellPoint did something really dumb with its capital, other than buying back
the news recently due to allegations it overcharged institutional customers for foreign-exchange services. Are those missteps not material concerns? JN: In December the company sold a large portion of the toxic assets to Goldman Sachs and Barclays Capital, which substantially de-risked the balance sheet. There are actually residual earnings from the similar assets they kept, which I consider non-operating earnings, but which I generally believe have a present value that will cover both the implementation costs of an ongoing organizational
INVESTMENT SNAPSHOT
restructuring and any potential payments to compensate wronged foreign-exchange customers. Theres clearly still uncertainty over that, but I expect the risk to be contained. Whats behind the organizational revamp? JN: Theyve made good acquisitions over time, but didnt really have the best expense discipline in integrating the businesses. The current CEO, who took over last year, has defined an ambitious overhaul plan to improve efficiency across the board, targeting $600 million in annual cost savings by 2014. Its a reasonable
goal, and would improve operating margins by approximately 500 basis points if the goal is met. On an EPS basis, the restructuring program is worth 80 cents per share in earnings if they meet their targets. At a recent $44.80, the shares trade at 14.5x the $3.10 in EPS reported for 2010. Where do you upside from there? JN: This year Im estimating EPS of $3.80 per share, increasing to $4.40 next year and $5.50 in 2013. Theres no big single driver behind that growth, but it assumes modest improvement on many fronts: organic industry growth, market share gains, continued growth in assets under management, cost savings, share buybacks, more normal interest margins, and a modest improvement in the important securities-lending operation. If Im right, by next summer forward twelve month EPS should be in the $5 range. Businesses like this can certainly trade at 15x forward earnings, which would result in a share price of $75. How would you characterize your general selling discipline? JN: My goal is to invest in companies and managements that create and compound value over a long period of time, so I can let the positions run. In those positive cases, my general guideline is that Ill start looking to sell when the IRR I expect from the current price approaches 10%. I also pay attention if a rising price causes a stocks P/E to go much above its historical median. This is a tricky one because theres no doubt it has in the past prompted me to sell sooner than I should have, but I havent abandoned it as a guidepost because of my ingrained fear of multiple contraction. The reality is that as hard as it is to let some companies go, things do have a way of coming back. Each of the four ideas I described in detail earlier were stocks Ive owned at least once for an extended period in the past. With a concentrated portfolio, Ill also sell something within a particular industry sector when I find something thats
State Street Corp.

(NYSE: STT)
Valuation Metrics
(@2/25/11):
Business: Trust bank in two primary businesses: outsourced financial custody and transaction services; and asset management, mostly through index funds and ETFs. Share Information
(@2/25/11):

(@12/31/10):
STT 14.5 12.3
S&P 500 18.6 13.9
Price
Financials (TTM):
44.80
32.47 50.26 0.1% $22.47 billion $8.93 billion 26.1% 17.4%
Company Massachusetts Fin Serv State Street Corp Capital Research Global Inv Vanguard Group Fidelity Mgmt & Research
% Owned 5.3% 4.8% 4.7% 3.6% 3.4% 1.3%

100 80 60 40 20 0

STT PRICE HISTORY 100 80 60 40 20 0
Shares Short/Float
2009
2010
2011
THE BOTTOM LINE
Benefitting from increasingly rational competition in custodial banking and a long-overdue organizational restructuring to cut costs, Jed Nussdorf expects the company to increase EPS at a better than 20% annual clip over the next three years. Assuming a 15x multiple on forward earnings, his target price for the shares 18 months out is $75.
February 28, 2011
more attractive and I dont want to increase my overall exposure. One example of that was my selling CIT Group [CIT] at the end of last year. Even though I still believe it has good prospects, there were other major lenders, specifically Wells Fargo [WFC], where I saw even greater potential. What about selling when things arent working out so well? JN: I have a pretty strict rule that if anything changes my perspective on a company so that my earnings estimates fall by more than 15%, I sell. You could legitimately argue a stock is even more attractive if its price falls 25% and your estimates only go down 15%, but that in many ways turns an offensive thesis into a defensive one, a dynamic I try to avoid. I actually liquidated 90% of my portfolio in November 2008. After reviewing every position individually, I concluded that I wouldnt short a single one of my shorts at the current prices and that my estimates for my longs had all fallen so
far that they breached my 15% threshold. So I covered almost all of my shorts and sold most of my longs. Which partly explains how you managed a positive return in 2008 of nearly 5%. JN: I was up 13% through July, while the market was down 13%. My net exposure steadily went down over the course of the year, from 75% at March 31, to 50% at June 30, to maybe 25% at the end of August. That was really nothing more than a function of my having an increasingly difficult time identifying the types of things I look for most of the topdown scenarios were negative, and the bottom-up ideas just werent there. So there was good performance in the first half, and the losses were limited in the second half due to lack of leverage and tighter exposures. When did you get back in? JN: That was the hard part, and it kept me from fully participating in the 2009
rebound. I dont know many examples of people who avoided the catastrophe of 2008 and were buying like crazy at the bottom in 2009. I would have loved to have been that guy, but I wasnt. That shows how hard it is to avoid recency bias, when what just happened inordinately informs your expectation of what will happen next. One of the best things Ive read on that is The Icarus Syndrome, by Peter Beinart. Its not about investing, but describes American hubris in foreign policy, in many cases resulting from doing what seemed to work in the previous ten years even if the setting was materially different or conditions had changed. One big problem is that all the people who succeed in the recent past become the ones in charge going forward, and they think they have it all figured out based on what they did before. Its all quite natural, but can result in some really bad decisions if you dont constantly challenge your core beliefs. Theres no obvious solution to the problem, but its something I try to be mindful of all the time. VII
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February 28, 2011
S T R A T E G Y : Seth Klarman
Our National Predicament

In these annual-letter excerpts, investing legend Seth Klarman explains why he believes no long-term lessons have been learned from 2008, defends short-selling, and describes the two key elements to investment success.
Editors Note: While its a given that the most revered investors over time have peerless investment performance, a secondary trait of many of them is a keen ability and willingness to articulate their investment processes and thinking. Warren Buffett, Peter Lynch and Joel Greenblatt, to name a few, are all exceedingly gifted writers who have made invaluable contributions to the investing canon. In this same league is Baupost Groups Seth Klarman, whose classic book, Margin of Safety, fetches thousands of dollars on eBay, and whose annual letters compete with those of Warren Buffett as must-reads among value investors. Below, reprinted with his permission, are three excerpts from his latest annual letter, from sections titled 2010 in Review and Our National Economic Predicament, Some Thoughts on the Demonization of Wall Street and Investment Firms, and A Reliable Framework for Investment Success. Two problems are upon us at once: short-term stimulus that is unaffordable over the long run and runaway entitlements that must be reined in. But restoring fiscal sanity will be bad for the economy and financial markets. What Treasury official or politician would want the cash spigot turned off before a recovery is certain? Recipients of government handouts a large percentage of the population would grumble at the termination of policies that offer them outsized benefits. So prepare for a chorus of "but not yet. One already sees this in editorials and commentaries, such as the ones saying it's time to close down bankrupt Fannie Mae and Freddie Mac, but not yet, because doing so would harm the still-weak housing market. There will never be a good time to end housing support programs, reverse quantitative easing policies, end fiscal stimulus, or reduce
February 28, 2011
massive budget deficits because doing so will restrict growth and depress share prices. Nor will there be a good time to cut entitlement programs or to solve Social Security or Medicare underfunding. All will agree the stimulus cannot go on forever, that excessive entitlements must be reined in, but not yet." The financial collapse of 2008 highlighted our national predicament. The sudden decline in consumer activity that
ON CRISIS LESSONS: Ironically, the first thing to rebound from the 2008 collapse isnt jobs or economic activity but speculation.
followed the plunges in the housing and stock markets represented a reasonable indeed a desirable response to overindebtedness. Yet the federal government saw this well-advised retrenchment as cataclysmic, because the national economy had grown dependent on our living beyond our means. The imagination of our financial leaders remains so shallow that their response to a crisis caused by overleverage and excess has been to recreate, as nearly as possible, the conditions that fomented it, as if the events of 2008 were a rogue wave of financial woe that can never recur. It is only in Fantasyland that the solution to vastly excessive debt is more debt and the answer to overconsumption is less saving and more spending. Worse still, we have yet to see a serious assessment by policymakers of the causes of the 2008 financial market and economic collapses so that we might take action to ward off a repeat performance. The governments knee-jerk response to contraction was to prop up economic activity by any and
every means possible; the hole in consumer activity had to be materially repaired on the government tab. While Treasury Secretary Timothy Geithner ingenuously professes a belief that the U.S. will never lose its AAA rating, Moody's recently warned that, absent a change, a downgrading could be just around the comer. Or, in the words of David Letterman, "I heard the U.S. debt may now lose its triple-A rating. And I said to myself, well who cares what the auto club thinks." Most of us learned about the Great Depression from our parents or grandparents who developed a "Depressionmentality," by which for decades people shunned leverage, embraced thrift, and thought twice before quitting their secure jobs to join risky ventures. By bailing out the economy rather than allowing the pain of the economic and market collapses to be felt, the government has endowed our generation with a "really-bad-coupleof-weeks-mentality": no lasting lessons are learned; the government endlessly intervenes in the economy, and, ironically, the first thing to strongly rebound from the 2008 collapse isn't jobs or economic activity but speculation. Benjamin Graham's margin-of-safety concept to invest at a sufficient discount so that even bad luck or the vicissitudes of the business cycle won't derail an investment is applicable to the economy as a whole. Bridges intended for tenton trucks are overbuilt by engineers to hold vehicles of 30 tons. Responsible investors assume their best judgments will sometimes go awry and insist on bargain purchases that allow room for error. Likewise, an economy built with no margin of safety will eventually implode. Governments that run huge deficits, promise entitlements that will be next-toimpossible to deliver, and depend on the beneficence of foreigners to stay afloat inevitably must collapse perhaps not
imminently but eventually, as Greece and Ireland have recently discovered. It is clear, both in the financial markets and in government policy, that no long-term lessons have been drawn from the events of 2008. A friend recently posited that adversity is valuable not for what it teaches but for what it reveals. The current episode of financial adversity reveals some unpleasant truths about the character and will of our country and its leaders, and offers an unpleasant picture of the future that awaits, unless we quickly find a way to change course. The Demonization of Short-Sellers While we rarely sell securities short both because of the degree of execution difficulty and theoretically unlimited risk compared to limited potential return we do believe that short-selling serves a vitally important function. Markets, of course, fluctuate; driven by human emotion, greed, and fear, they can reach significantly overvalued levels. This is bad, both because it can induce some who cannot afford losses to speculate, and because it can lead to an improper allocation of society's resources. The recent housing bubble illustrates the problem: excessive home prices led to excessive home building, eventually resulting in a price collapse, large loan losses, and great personal hardship. In addition, the decline that follows periods of market overvaluation is bad for the broader economy, for confidence, and for rational decision making; it also frequently triggers government intervention in markets, with all of its inevitable distorting effects. Just as value buyers can dampen downside volatility, short-sellers can dampen the upside excesses. They don't actually change the eventual outcomes, just help us get there sooner. This makes short-sellers unpopular, as the uninformed masses enjoy high and rising securities prices for the short-term profits they produce, without understanding the societal costs of the future reversal. The less you understand valuation, the more that overvaluation seems like a free lunch which of course it isn't.
February 28, 2011
From our experience, much long-oriented analysis is simplistic, highly optimistic, and sloppy. Short-sellers, by going against the long-term tide of economic growth and the short-term swells of public opinion and margins calls, are forced to be crackerjack analysts. Their work product is usually top-notch and needs to be. Short-sellers shouldn't be reviled or banned; most should be celebrated and encouraged. They are the policemen of the financial markets, identifying frauds and cautioning against bubbles. In effect, they protect the unsophisticated from predatory schemes that regulators and
fickle, volatile, subject to the influence of malicious gossip, and short-term oriented. In any event, mechanisms such as the uptick rule and rules against market manipulation already exist to prevent such misbehavior by short-sellers. A Framework for Investment Success Two elements are vital in designing an investment approach for long-term success. First, answer the question, ''what's your edge?" In highly competitive financial markets, with thousands of very smart, hardworking participants, what will enable you to reliably outperform the field? Your toolkit is critically important: truly long-term capital; a flexible approach that enables you to move opportunistically across a broad array of markets, securities, and asset classes; deep industry knowledge; strong sourcing relationships; and a solid grounding in value investing principles. But because investing is, in many ways, a zero-sum activity in which your returns above the market indices are derived from the mistakes, overreactions or inattention of others as much as from your own clever insights, there is a second element in designing a sound investment approach: you must consider the competitive landscape and the behavior of other market participants. As in football, you are well-advised to take advantage of what your opponents give you: if they are defending the run, passing is probably your best option, even if you have a star running back. If scores of other investors are rigidly committed to fast-growing technology stocks, your brilliant tech analyst may not be able to help you outperform. If your competitors are not paying attention to, or indeed are dumping, Greek equities or U.S. housing debt, these asset classes may be worth your attention, regardless of the currently poor fundamentals that are driving others' decisions. Where to best apply your focus and skills depends partially on where others are applying theirs. When observing your competitors, your focus should be on their approach
ON COMPETITORS: Your returns are derived from the mistakes, overreactions or inattention of others as much as from your clever insights.
enforcement agencies don't seem able to prevent. Moreover, the short-seller who is fundamentally wrong, who mistakenly sells short an undervalued security, will lose money and, if the pattern continues, will eventually go broke. Short-sellers, like long-only buyers, need to be right more than they are wrong; when they are right, their actions are socially beneficial, not harmful. The only exception to this point, the only danger short-sellers pose to society, is when, in the equivalent of yelling "fire" in a crowded theatre, they spread false rumors that prevent a company that needs regular financing (such as brokerage firms) from being funded. Then, their predictions become self-fulfilling prophecies, enabling them to profit, whether or not they were fundamentally correct; they may actually be able to change the outcome. Yet, even in this situation, one may wonder whether any company or highly leveraged government, for that matter should employ a funding model that depends on perpetual access to the capital markets, which are notoriously
and process, not their results. Short-term performance envy causes many of the shortcomings that lock most investors into a perpetual cycle of underachievement. You should watch your competitors not out of jealousy, but out of respect, and focus your efforts not on replicating others' portfolios, but on looking for opportunities where they are not. Much of the investment business is centered around asset-gathering activities. In a field dominated by a short-term, relative performance orientation, significant underperformance is disastrous for retention of assets, while mediocre performance is not. Thus, because protracted periods of underperformance can threaten one's business, most investment firms aim for assured, trend-following mediocrity while shunning the potential achievement of strong outperformance. The only way for investors to significantly outperform is to periodically stand far apart from the crowd, something few are willing or able to do. In addition, most traditional investors are limited by a variety of constraints: narrow skill-sets, legal restrictions contained in investment prospectuses or partnership agreements, or psychological inhibitions. High-grade bond funds can only purchase investment-grade bonds; when a bond falls below BBB, they are typically forced to sell (or think that they should), regardless of price. When a mortgage security is downgraded because it will not return par to its holders, a large swath of potential purchasers will not even consider buying it, and many must purge it. When a company omits a cash dividend, some equity funds are obliged to sell that stock. And, of course, when a stock is deleted from an index, it must immediately be dumped by many. Sometimes, a drop in a stock's price is reason enough for some holders to sell. Such behavior often creates supplydemand imbalances where bargains can be found. The dimly lit comers and crevasses existing outside of mainstream mandates may contain opportunity. Given that time is often an investor's scarcest resource, filling ones in-box with the most compelling potential
February 28, 2011
opportunities that others are forced to or choose to sell (or are constrained from buying) makes great sense. Price is perhaps the single most important criterion in sound investment decision making. Every security or asset is a "buy" at one price, a hold at a higher price, and a "sell" at some still higher price. Yet most investors in all asset classes love simplicity, rosy outlooks, and the prospect of smooth sailing. They prefer what is performing well to what has recently lagged, often regardless of price. They prefer full
ON RISK: When one feels the fear that accompanies plunging market prices, risk-taking becomes considerably less risky.
buildings and trophy properties to fixeruppers that need to be filled, even though empty or unloved buildings may be the far more compelling, and even safer, investments. Because investors are not usually penalized for adhering to conventional practices, doing so is the less professionally risky strategy, even though it virtually guarantees against superior performance. Finally, most investors feel compelled to be fully invested at all times principally because evaluation of their performance is both frequent and relative. For them, it is almost as if investing were merely a game and no client's hardearned money was at risk. To require full investment all the time is to remove an important tool from investors' toolkits: the ability to wait patiently for compelling opportunities that may arise in the future. Moreover, an investor who is too worried about missing out on the upside of a potential investment may be exposing himself to substantial downside risk precisely when valuation is extended. A thoughtful investment approach focuses at least as much on risk as on return. But in the moment-bywww.valueinvestorinsight.com
moment frenzy of the markets, all the pressure is on generating returns, risk be damned. What drives long-term investment success? In the Internet era, everyone has a voluminous amount of information but not everyone knows how to use it. A well-considered investment process thoughtful, intellectually honest, teamoriented, and single-mindedly focused on making good investment decisions at every turn can make all of the difference. Investors with short time horizons are oblivious to kernels of information that may influence investment outcomes years from now. Everyone can ask questions, but not everyone can identify the right questions to ask. Everyone searches for opportunity, but most look only where the searching is straightforward even if undeniably highly competitive. In the markets of late 2008, everything was for sale as investors were caught in a contagion of selling due to panic, margin calls, and investor redemptions. Even while modeling very conservative scenarios, many securities could have been purchased at extremely attractive prices if one had capital with which to buy them and the stamina to hold them in the face of falling prices. By late 2010, froth had returned to the markets, as investors with short-term relative performance orientations sought to keep up with the herd. Exuberant buying had replaced frenzied selling, as investors purchased securities offering limited returns even on far rosier economic assumptions. Most investors take comfort from calm, steadily rising markets; roiling markets can drive investor panic. But these conventional reactions are inverted. When all feels calm and prices surge, the markets may feel safe; but, in fact, they are dangerous because few investors are focusing on risk. When one feels in the pit of one's stomach the fear that accompanies plunging market prices, risk-taking becomes considerably less risky, because risk is often priced into an asset's lower market valuation. Investment success requires standing apart from the frenzy the short-term,
relative performance game played by most investors. Investment success also requires remembering that securities prices are not blips on a Bloomberg terminal but are fractional interests in or claims on companies. Business fundamentals, not price quotations, convey useful information. With so many market participants fixated on short-term investment performance, successful investing requires a focus not on how one is doing, but on corporate balance sheets and income and cash flow statements. Government interventions are a wild card for even the most disciplined investors. On one hand, the U.S. government has regularly intervened in markets for decades, especially by lowering interest rates at the first sign of bad economic news, which has the effect of artificially inflating securities prices. Today, monetary easing and fiscal stimulus augment consumer demand, increasing risks not
only regarding the integrity and sustainability of securities prices but also those surrounding the sustainability of business results. It is hard for investors to get their bearings when they cannot readily distinguish durable business performance from ephemeral results. Endless manipulation of government statistics adds to the challenge of determining the sustainability and therefore the proper valuation of business performance. As securities prices are propped up and interest rates are manipulated sharply lower (thereby justifying those higher prices in the minds of many), prudent investors must demand a wide margin of safety. This is especially so because financial excesses contain the seeds of their own destruction. Market exuberance leads to business exuberance production of more goods and services than demand ultimately justifies. Of course, when market and economic excesses are finally corrected, there is a tendency to over-
shoot, creating low-risk opportunities for value investors who have remained patient and disciplined. Yet another long-term risk confronts investors: the government's fiscal and monetary experiments may go awry, resulting in runaway inflation or currency collapse. Bottom-up value investors would not wish to bet the ranch on a macroeconomic view, but neither would they be wise to ignore the macroeconomy altogether. Disaster hedging always an important tool for investors takes on heightened significance in today's unprecedentedly challenging environment. Yet, as this insight is not unique to us, the cost of insurance is high. There are no easy ways to navigate these turbulent waters. But because the greatest risks are of currency debasement and runaway inflation, protection against a currency collapse such as exposure to gold and against much higher interest rates seem like necessary hedges to maintain. VII
February 28, 2011
U N C O V E R I N G V A L U E : Alliance One
Turning Over a New Leaf

Suffice it say that a Michael Porter five forces analysis of Alliance One Internationals business quality wouldnt generate significant enthusiasm. But that doesnt mean it wont be a rewarding investment.
A common theme for some time now among accomplished investors has been that the stocks of blue-chip companies were bargains. We've operated through seven bear markets, said Southeastern Asset Management's Mason Hawkins last summer (VII, August 27, 2010), and what's unique about this one is the opportunity it has created in the stocks of the highest-quality companies. Alliance One International is not one of those companies. It is one of two large global processors of tobacco the other is publicly traded Universal Corp. [UVV] who source tobacco directly from farmers, process it, pack it and deliver it to the small number of giant tobacco companies around the world. Margins are thin and pricing power is non-existent. Given the vagaries of customer ordering patterns, weather and crop yields, earnings can swing sharply from quarter to quarter. The company's stock performance has also been anything but blue-chip. Alliance shares, at a recent $3.60, are off nearly 30% in the past year a period in which the S&P 500 is up 19%. Investors appear spooked by two successive poor quarters, an oversupplied tobacco market pushing down prices, and recent moves by customers Japan Tobacco and Philip Morris International to bring additional processing functions in house. Bryan Jacoboski of Abingdon Capital (VII, August 29, 2005) believes the negativity about Alliance One has gone too far. Oversupplied markets self-correct, he says, as farmers switch capacity to higher priced crops. He sees no evidence that the company has ceded competitive ground in a market where scale matters and it and Universal share roughly 70% of the market. Finally, while most customers have always been partially vertically integrated, he expects the recent moves by Japan Tobacco and Philip Morris to prove the exception rather than the rule. Operating margins on tobacco processFebruary 28, 2011
ing are one-half to one-quarter those of selling cigarettes, he says. Why get into processing in a big way? Alliance One shares trade today for only 4.5x the 80 cents per share he believes the company can earn in a normal year, and 3.3x the hard EPS minimum of $1.10 it must earn before management receives any long-term incentive pay. (Earnings were $1.49 per share in fiscal 2009.) He expects Mark Kehaya, a board member and large shareholder who recently took over as CEO, to aggressiveINVESTMENT SNAPSHOT
ly cut costs and pay down debt, while investing in emerging markets, where cigarette consumption is still growing. Valuing the shares at 10x his earningspower estimate, Jacoboski believes the shares are worth $8, more than double today's level, even if management falls short of its EPS objective. There's an old adage in the insurance business that there are no bad risks, only bad prices, he says. The same is true in investing. This may not be a great business, but it's available at a great price. VII
Alliance One
(NYSE: AOI)
Business: Buys, processes and sells leaf tobacco to manufacturers of cigarettes and other tobacco products worldwide. Share Information (@2/25/11):
Valuation Metrics
(@2/25/11):

(@12/31/11):
AOI 7.3 n/a
S&P 500 18.6 13.9
Price
Financials (TTM):
3.60
3.17 5.45 0.0% $313.5 million $2.14 billion 7.3% 2.4%
Company Baupost Group T. Rowe Price Dimensional Fund Adv

% Owned 10.1% 6.5% 5.3% 9.3%

8 7 6 5 4 3 2

AOI PRICE HISTORY 8 7 6 5 4 3 2 2009 THE BOTTOM LINE
Shares Short/Float
2010
2011
Trading at only 3.3x Bryan Jacoboskis estimate of normalized earnings, the companys stock appears to reflect market fears that challenges he considers temporary are more permanent. If hes proven right, he believes the shares are worth at least $8.
EDITORS LETTER
The Spice of Life

We heard a novel reason earlier this month for a manager whose performance we respect to decline to be interviewed in Value Investor Insight: You're a value investing publication, said the manager's PR representative, but they are core investors and don't want to confuse current or potential investors. Setting aside our own confusion about what a core investor is, we respectfully disagree with this comments premise. Our view of value investing is both broad and simple: endeavoring to pay less than you believe something is worth. That difference between price and value can result from a stock being excessively out of favor for market, industry or companyspecific reasons (the classic value profile), or because the market is underestimating how strong the company's earnings growth will be (the classic growth profile). If making either case or the many renditions in between in our humble publication would serve to confuse investors, well, those investors should be buying index funds anyway. Oakmark Funds' Bill Nygren (VII, July 28, 2006) elaborated on this general view when asked recently by Morningstar
Value Investor Insight is published monthly at www.valueinvestorinsight.com (the Site), by Value Investor Media, Inc. Chairman and Co-Editor-in-Chief, Whitney Tilson; President and Co-Editor-in-Chief, John Heins. Annual subscription price: $349.
2011 by Value Investor Media, Inc. All rights reserved. All Site content is protected by U.S. and international copyright laws and is the property of VIM and any third-party providers of such content. The U.S. Copyright Act imposes liability of up to $150,000 for each act of willful infringement of a copyright.
if he had become more willing than in the past to invest in growth companies:
Positioning value versus growth sets up a false comparison. They are not opposite ends of the spectrum value investing and momentum investing are at opposite ends. All else equal, after a stock price falls with no change in its estimated value, a value investor will find it more attractive. A momentum investor reacts in the opposite way; a price decline makes the stock less attractive, and vice versa. A value investor needs to be able to assess the value of many business characteristics, such as balance sheet strength, cash-generating ability, franchise durability, and so on. Growth is also one of those factors. The ability to grow organically is almost always a positive. It would be a negative only if that growth required so much investment that it had a negative present value. That almost never happens. Ten to 15 years ago, investors were paying a very high price for growth. Many stocks traded at barely doubledigit P/Es, but large-cap companies that had above-average expected growth were trading at 50 times earn-
ings and higher. At that spread, we believed growth was way too expensive, and it was an easy choice to avoid it. More recently, valuations have compressed, meaning the price of growth has sharply fallen. When we can get more growth without having to pay for it, the choice again becomes very easy. I see value investing as applying a consistent discipline to a changing marketplace. As the price investors pay for growth becomes excessive, applying our price discipline moves us away from growth. As the price for growth declines, our discipline moves us toward higher-growth businesses.
This issue marks VIIs sixth anniversary. It has been our great honor to profile the best investors in the business, each of whom comes at the task with his or her own unique and evolving take on what constitutes a good value. Variety is, as they say, the spice of life. VII
John Heins Co-Editor-in-Chief
Whitney Tilson Co-Editor-in-Chief
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February 28, 2011
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Value Investor Insight and SuperInvestor Insight are published at www.valueinvestorinsight.com (the Site) by Value Investor Media, Inc. Use of this newsletter and its content is governed by the Site Terms of Use described in detail at www.valueinvestorinsight.com/misc/termsofuse. For your convenience, a summary of certain key policies, disclosures and disclaimers is reproduced below. This summary is meant in no way to limit or otherwise circumscribe the full scope and effect of the complete Terms of Use. No Investment Advice This newsletter is not an offer to sell or the solicitation of an offer to buy any security in any jurisdiction where such an offer or solicitation would be illegal. This newsletter is distributed for informational purposes only and should not be construed as investment advice or a recommendation to sell or buy any security or other investment, or undertake any investment strategy. It does not constitute a general or personal recommendation or take into account the particular investment objectives, financ ial situations, or needs of individual investors. The price and value of securities referred to in this newsletter will fluctuate. Past performance is not a guide to future performance, future returns are not guaranteed, and a loss of all of the original capital invested in a security discussed in this newsletter may occur. Certain transactions, including those involving futures, options, and other derivatives, give rise to substantial risk and are not suitable for all investors. Disclaimers There are no warranties, expressed or implied, as to the accuracy, completeness, or results obtained from any information set forth in this newsletter. Value Investor Media will not be liable to you or anyone else for any loss or injury resulting directly or indirectly from the use of the information contained in this newsletter, caused in whole or in part by its negligence in compiling, interpreting, reporting or delivering the content in this newsletter. Related Persons Value Investor Medias officers, directors, employees and/or principals (collectively Related Persons) may have positions in and may, from time to time, make purchases or sales of the securities or other investments discussed or evaluated in this newsletter. Whitney Tilson, Chairman of Value Investor Media, is also a principal of T2 Partners Management, LP, a registered investment adviser. T2Partners Management, LP may purchase or sell securities and financial instruments discussed in this newsletter on behalf of certain accounts it manages. It is the policy of T2 Partners Management, LP and all Related Persons to allow a full trading day to elapse after the publication of this newsletter before purchases or sales are made of any securities or financial instruments discussed herein as Investment Snapshots. Compensation Value Investor Media, Inc. receives compensation in connection with the publication of this newsletter only in the form of subscription fees charged to subscribers and reproduction or re-dissemination fees charged to subscribers or others interested in the newsletter content.
February 28, 2011
Value Investor Insight

ValueInvestorInsight Issue 284

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ValueInvestorInsight Issue 284

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ValueInvestor

February 28, 2011

The Leading Authority on Value Investing

Inside this Issue

Other companies in this issue:

Investor Insight: Jon Jacobson

Trailing P/E Forward P/E Est.

DTV 27.3 11.7

Nasdaq 13.8 16.3

Largest Institutional Owners

% Owned 6.9% 6.1% 4.8% 4.3% 3.7% 1.4%

Revenue Operating Profit Margin Net Profit Margin

THE BOTTOM LINE

February 28, 2011

Trailing P/E Forward P/E Est.

CVS 13.2 11.9

S&P 500 18.6 13.9

Largest Institutional Owners

% Owned 5.0% 4.3% 3.7% 3.6% 3.5% 0.9%

Revenue Operating Profit Margin Net Profit Margin

20 2009 2010 2011

THE BOTTOM LINE

Value Investor Insight 6

Trailing P/E Forward P/E Est.

SLM 15.9 9.1

S&P 500 18.6 13.9

Largest Institutional Owners

% Owned 10.1% 9.9% 9.0% 7.9% 6.2% 1.7%

Revenue Operating Profit Margin Net Profit Margin

THE BOTTOM LINE

Value Investor Insight 7

Revenue Operating Profit Margin Net Profit Margin

$73.49 billion 14.4% 25.1%

1.75 1.26 1.85 5.4% 90.54 billion

S&P 500 18.6

VOD:LN PRICE HISTORY 2.00

THE BOTTOM LINE

Value Investor Insight 8

Investor Insight: Jed Nussdorf

Haste not Waste

Trailing P/E Forward P/E Est.

ACGL 5.8 11.1

Nasdaq 13.8 16.3

Largest Institutional Owners

% Owned 9.6% 6.3% 3.0% 2.1% 2.0% 4.9%

Revenue Operating Profit Margin Net Profit Margin

40 2009 2010 2011

THE BOTTOM LINE

Value Investor Insight 12

Financials (First half 2010)

AUM @ 6/30/10 Pre-Tax Profit Margin Net Profit Margin

CHF 116.6 billion 36.9% 28.9%

S&P 500 18.6

GAM:SW PRICE HISTORY 20 15 10 5 0

THE BOTTOM LINE

Value Investor Insight 13

Trailing P/E Forward P/E Est.

WLP 9.6 10.1

S&P 500 18.6 13.9

Largest Institutional Owners

% Owned 4.3% 3.7% 3.6% 3.2% 2.9% 0.9%

Revenue Operating Profit Margin Net Profit Margin

THE BOTTOM LINE